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Biased notes on risk, investment and life.

Sunday, September 7, 2014

One of more entertaining reads last week was Roche’s post “The Fallacy of the “EMH Twist”. While I always find his posts insightful and thought provoking, his fight against efficient market hypothesis (EMH) usually reminds me of Don Quixote’s battles.
I have always considered the debate about EMH as being at least a little bit silly, mostly because in my life I have never met a person, who would argue that markets are truly efficient. Absolutely everyone I have ever had a chance to discuss the topic with were saying that “markets are efficient, but…”

Market efficiency and “alpha”

Like many other people, I tend to consider markets to be “kind of” efficient. Increasing transparency of the markets and capacity to process information makes it is hard to argue that information is not almost instantaneously incorporated in market prices. Our capacity to process information is more questionable, therefore, I tend to go even further than classical EMH by claiming that market prices incorporate all the effects of biases and modeling errors in investment decision making. To sum up, I believe that market prices represent collective thinking of all the participants at any particular time.
At the same time, I do believe that it is possible to earn “alpha”, but it is very very hard. While it might seem like a contradiction to belief in market efficiency, I do consider EMH to be more as a general principal or a tendency of the market. Even in the markets that tend to be efficient “on average” inefficiencies might still exist.
Although market prices are a representation of collective thinking of all the investors, they are not a representation of intrinsic values. Inefficiencies might exist in the markets that are less transparent and/or relatively neglected by investors (where collective thinking lacks depth). They can also exist in the market affected by cognitive or emotional biases (where collective thinking of investors is wrong).

Accepting market efficiency vs. buy cheap ETF

Accepting even “kind of” efficient market hypothesis suggest that consistently earning excess risk-adjusted returns is very hard, if not impossible. That does not mean, however, we should all buy the market index and forget about active investing.
Many investment commentators tend to oversimplify implications of market efficiency and recommend “passive investing” by buying low commission funds following market indices. As Roche correctly notes in his other post, there is no such thing as “passive investing”. As long as there is no a “cheap” ETF that perfectly replicates the performance of all the financial market, every investment decisions we make has elements of active investing.
Furthermore, market portfolio is far from optimal for an absolute majority of the investors, and should not be considered as a viable option even if available. While average market performance might be suitable for an average investor, that investor does not exist in reality. Therefore every investor, who chooses not to try his skills and luck in the hunt of market inefficiencies, still needs to actively choose a portfolio which matches his needs. In other words, completely “passive investing” is not only impossible but also not desirable for many investors.

Conclusions

Although I do mostly agree with Roche’s conclusions on passive investing, I do see the problem not in Efficient Market Hypothesis, but rather in common misinterpretation of it. First, EMH, as all other theoretical concepts, is an oversimplification and should not be applied directly, without considering all the constraints. Second, acceptance of the EMH does not directly imply that we should all buy the market index, without making any active decisions. Third, buying cheap index-tracking ETFs is not the same as buying the market index.